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The effect of human emotions in stock market

This might be a good time to talk about stock market bubbles. Not that they matter to the long-term buy-and-hold investor, but as an object of curiosity they are interesting to watch. For 401(k) investors or anyone steadily depositing money on a monthly basis, the overreaction caused by a bursting bubble typically reduces stock prices to values below the intrinsic value of the companies whose real values (based on income statements and balance sheets) they are supposed to reflect. In other words, when stocks plunge they make it possible to buy still- valuable companies (singly or through mutual funds) for 50 cents on the dollar --- or better.

As goofy as it may sound, we want to pray that stocks crash occasionally. However, it can still be unsettling to watch those account balances drift lower and lower from quarter to quarter. The problem with the stock market is that it is a complex system with the totally unpredictable consequences of human emotion added to a matrix that includes further unpredictable events like the future level of interest rates --- to mention just one of many concrete variables. Concrete in that the interest rate is a solid number while emotions resist quantification.

People call me today who are concerned about Greece --- a country whose economy is about the size of Miami’s. As a part of the world’s economy, Greece is a rounding error. However, thanks to the effect of human emotion on stock values, the problems in Greece can impact stock prices around the world as we have just seen. In fact, the damage in Greece has already been done. So now we wait to see what fallout results.

Our interest in bubbles is prompted by the extent to which they lead to crashes. A crash has never occurred when times looked bad. So a bubble, the underpinnings of which is the collective feeling that times are good, is worth watching to the extent that the stage is set for a crash. My economy professor, John Kenneth Galbraith, was famous for pointing out that bubbles are supported by “conventional wisdom” --- smart people offering supporting arguments as to why good times will continue.

Robert Shiller, Yale professor and author of “Irrational Exhuberance,” is interviewed in the latest AAII Journal (American Association of Independent Investors) where he starts by defining bubbles as “a kind of social epidemic … where price increases generate enthusiasm which then … bids up prices more.” He goes on to say that stories develop which justify the bubble and people believe them because everyone’s confirming the stories. “Conventional wisdom,” in other words.

All that is required to prick the bubble is something that derails the human emotion element that rattles around in the echo chamber of conventional wisdom. Since a bubble exists in an atmosphere of general well-being, something has to trigger attention to the fact that assets are overpriced --- that the king has no clothes. In theory, markets are supposed to be ‘efficient” and arrive automatically at stock prices that accurately reflect the value of publicly-held companies. However, the so-called “wisdom of crowds” doesn’t work as well when the crowds are made up of people. Stories as insignificant as Greece today, or programmed trading back in 1987, or the Lehman Brothers’ failure in 2007 are sometimes all it takes to set the cascade in motion.

The antidote, according to Shiller, is diversification across different industries, countries, and asset classes. This approach is better than trying to second guess when a bubble is about to burst. Selling out (an attempt to time the crash) may lead to opportunity costs as good times continue to persist. Today, there are few alternatives to the stock market when we look at paltry bond yields, for example, but there is opportunity within the stock market to reduce the cost of a bubble-induced collapse. Start with established companies that pay dividends both here at home and throughout the world. Then grip the arms of your chair as tightly as you can while you live through the crash and its inevitable “snapback.”

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